## A Review: “Two Centuries of Trend Following”

The paper “Two Centuries of Trend Following” by Lemperiere, Derenble, Seager, et al of Capital Fund Management purports to show that trend following has been profitable, over a wide range of markets, consistently over 200 years. It deserves to be reviewed as it represents a case study of the statistical practices, and armchair explanations that are sometimes used to justify a system that in the most recent five year period has lost its mojo. Rocky has asked me to review it.

The amazing thing is that the authors seem to know how to compute hyperbolic tangent regressions, and compute the duration of a drawdown given a sharpe ratio, yet they seem completely unaware of the problem of multicollinearity, overlapping observations, and lack of independent observations.

In a nutshell, they compute hundreds of thousands of means, and they combine them and measure how far away from randomness they are. Recall that the average of two random observations is about 0.7 times as variable as one observations. The average of 100,000 observations is about 1/320 as variable as 1 observation. (more…)

• Preparation:  If you put yourself in the best possible position and you lose money at least you spent that money wisely.  Good things happen to those that are prepared because 90% of people do not know how to do it or are unwilling.
• Purpose: Acting with purpose.  You prepared, you knew the risks, you executed the way you wanted to execute.  In cold blooded evaluation you would do it the same with the information you had at the time.
• Protection:  Losing the invisible money is how I have seen many people blow up.  Invisible money is not locking in profits or losing more than your plan allowed.  If you lose what you intended to risk you own the trade, if you lose more the trade owns you.

Your goal as a trader is to always reduce the time it takes to analyze, react, and recover.  The best traders do this effortlessly after much thought, experiment, and practice.  I lacked confidence because I thought about the wrong things or not at all and I was doing random things all of which made it too costly, emotionally and financially, to practice.

## Constructing Diversified Futures Trading Strategies

• Once you reach a few million under management, hiring a research staff to improve details is a good idea.
• Wait for momentum to build in one direction and get on the bandwagon.  Expect to lose about two thirds of the time and so make sure your winners can pay for the losers and leave enough over to cover the rent.
• Using a single strategy on a single instrument is for people with either extreme skill or for those who simply have a death wish
• If we put the same notional dollar amount in each trade the portfolio would immediately be dominated by the volatile instruments and not much impact at all would come from the less volatile.
• Trend following: Buying high and selling higher
• Non professionals tend to spend an excess of time and energy on the buy and sell rules and neglect diversification and risk

## 5 Points for Discretionary Traders

1)  A discipline of pre-market preparation:  All emphasize the importance of process and preparation: sticking to what you do best and being prepared for fresh opportunity–and threat–each market day.

2)  Selectivity:  All have some methods for screening stocks and focusing on a core group that offer opportunity.  Often, these screens focus on stocks that are trading actively, that show good movement, and that are setting up for directional price moves because of earnings reports, breakout patterns, etc.

3)  Patience:  This follows from the first two.  The experienced traders emphasize risk management and waiting for high quality trades, rather than overtrading.  All stress understanding the current market environment and adapting to it.

4)  Diversification:  These traders don’t focus on one or two opportunities, but look at a range of promising shares and setups and trade more than one thing at a time.  All the proverbial eggs are not in one basket.

5)  Simplicity:  My sense is that the traders are focused on understanding what is happening now, not predicting what will happen in the future.  If I had to guess, I’d say that they are talented in detecting the flow of activity in and out of shares and are riding moves as they are getting under way.  They don’t appear to be researching deep value and holding for long periods to wait for that value to be realized.

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